The Fed Blog

Wednesday, March 29, 2017

The global economy fell into a growth recession from mid-2014 through early 2016. It was caused by a severe recession in the global commodities sector, led by a collapse in oil prices. It was widely expected that the negative consequences of lower oil prices for producers would be more than offset by the positive ones for consumers. That was not the case. The former outweighed the latter because the commodity-related cuts in capital spending overshadowed the boost to consumer spending from lower oil prices. In addition, there was a brief credit crunch in the high-yield market on fears that commodity producers would default on their bonds and trigger a widespread financial contagion.

Now the worst is over for commodity producers, as their prices have rebounded. That’s because they scrambled to reduce output and restructure their operations to be more profitable at lower prices. More importantly, global demand for commodities remained solid. Now with commodity prices, especially oil prices, well below their 2014 highs, consumers are benefitting more than producers are suffering.

Voila! The global economy is showing more signs of improving in recent months. That’s already boosting revenues growth for the S&P 500, and should be increasingly obvious as corporations report their top-line growth rates for the Q1 earnings season during April. Let’s have a closer look:

(1) Commodity prices. The CRB raw industrials spot price index fell 27% from April 24, 2014 through November 23, 2015. The index is up 28% from the low. The price of a barrel of Brent crude oil plunged 76% from its 2014 high of $115.06 on June 19 to its 2016 low of $27.88 on January 20. It is up 84% from its low to $51.28 yesterday.

(2) Business sales. US manufacturers’ shipments of petroleum products plunged 58% from the end of 2013 through February 2016. That drop weighed heavily on US manufacturing and trade sales, which declined on a y/y basis each month from January 2015 through July 2016. Excluding petroleum shipments, this broad measure of business sales of goods barely grew during this energy recession.

(3) S&P 500 revenues. I am not surprised to see S&P 500 revenues tracing out the same pattern as business sales since I have been tracking the close relationship of the two for some time. The y/y growth rates of business sales and S&P 500 revenues (either on an aggregate or per-share basis) continue to be very close. The same goes for the relationship excluding Energy revenues from the S&P 500 aggregate and business sales excluding petroleum shipments.

I continue to monitor analysts’ expectations for the short-term (year-ahead) growth rates of S&P 500 revenues and earnings (STRG and STEG), as well as long-term (five-year-ahead) earnings growth (LTEG) on a weekly basis. STRG has rebounded from close to zero in early 2015 to about 5.5% currently. Since the start of last year, STEG has jumped from about 5% to over 10%. LTEG is around 12.3%, near the best reading of the current economic expansion.

I doubt that any of these improvements have much to do with Trump’s election victory. I have no doubts that the end of the global Energy sector’s recession accounts for much of the improvement.

(4) Business surveys. Another upbeat indicator for S&P 500 revenues is the M-PMI, which has a good correlation with the y/y growth rate in S&P 500 revenues (both in aggregate and per-share). The former jumped from a recent low of 49.4 during August 2016 to 57.7 during February, the best level since August 2014. That too is consistent with a manufacturing recovery following the end of the energy recession, and augurs well for revenues growth.

By the way, there is a similarly good correlation between revenues growth and the composite business indicators from the regional surveys conducted by five Fed districts. All five are available through March, with their average index jumping from last year’s low of -12.8 to 21.6 this month. The energy recession is clearly over.

Wednesday, March 22, 2017

There are plenty of age-old adages about the stock market that focus on the Fed’s impact on the market. They tend to be cautionary and are recited by old timers who’ve lived through some wicked bear markets and fearsome corrections. The basic message is that the Fed is your friend until it isn’t. Consider the following:

(1) Zweig. Martin Zweig was a highly respected analyst and investor who passed away in 2013. He famously often said “Don’t fight the Fed.” He started his newsletter in 1971 and his hedge fund in 1984. On Friday, October 16, 1987, in a memorable appearance on Wall Street Week with Louis Rukeyser, he warned of an imminent stock market crash. It happened the following Monday, and Zweig became an investment rock star. His newsletter, The Zweig Forecast, had a stellar track record, according to Mark Hulbert, who tracks such things.

In his 1986 book Winning on Wall Street, Zweig elaborated on his famous saying:
“Monetary conditions exert an enormous influence on stock prices. Indeed, the monetary climate—primarily the trend in interest rates and Federal Reserve policy—is the dominant factor in determining the stock market’s major direction. … Generally, a rising trend in rates is bearish for stocks; a falling trend is bullish.” There are two reasons for this, he wrote: “First, falling interest rates reduce the competition on stocks from other investments, especially short-term instruments such as Treasury bills, certificates of deposit, or money market funds. … Second, when interest rates fall, it costs corporations less to borrow. … As expenses fall, profits rise. … So, as interest rates drop, investors tend to bid prices higher, partly on the expectation of better earnings. The opposite effect occurs when interest rates rise.”

(2) Martin. In 1949, President Harry Truman appointed Scott Paper CEO Thomas McCabe to run the Fed. McCabe pushed to regain the Fed’s power over monetary policy and did so with the Fed-Treasury Accord of 1951. He negotiated the deal with Assistant Treasury Secretary William McChesney Martin. McCabe returned to Scott Paper and Martin took over as chairman of a re-empowered Federal Reserve on April 2, 1951, serving in that position until January 31, 1970 under five presidents. The March 1951 Accord freed the Fed and marked the start of the modern Federal Reserve System. Under Martin, the Fed’s overriding goals became price and macroeconomic stability. He believed that the Fed’s job was to be a party pooper. His famous “punch bowl” metaphor seems to trace back to a speech given on October 19, 1955 in which he said:

“In the field of monetary and credit policy, precautionary action to prevent inflationary excesses is bound to have some onerous effects—if it did not it would be ineffective and futile. Those who have the task of making such policy don’t expect you to applaud. The Federal Reserve, as one writer put it, after the recent increase in the discount rate, is in the position of the chaperone who has ordered the punch bowl removed just when the party was really warming up.”

(3) Gould. According to the Market Technicians Association, the late technical analysis pioneer Edson Gould, who was active from the 1930s through the 1970s, observed that “whenever the Federal Reserve raises either the federal funds target rate, margin requirements, or reserve requirements three times without a decline, the stock market is likely to suffer a substantial, perhaps serious, setback.” This adage is widely known as “three steps and a stumble.” So far, investors are betting against it since stocks actually rose sharply last Wednesday after the Fed hiked the federal funds rate for the third time since the Great Recession.

What do the data show about the relationship between the Fed’s monetary policy cycle and the S&P 500? Monthly data for the index show that it tends to bottom during the beginning of easing phases of monetary policy, when the Fed is lowering the federal funds rate. It tends to continue rising through the end of the easing phases and even when the Fed starts raising interest rates. Three rate hikes may cause occasional stumbles, but it’s hard to see them in the data.

What does stand out is that the tightening phase of monetary policy often ends in tears because it tends to trigger financial crises. Forward P/Es have a tendency to peak before the crises hit as investors begin to fret that higher interest rates may be starting to stress the economy.

Wednesday, March 15, 2017

The Fed released its Financial Accounts of the United States with data for Q4-2016 last week. It provides amazingly comprehensive insights into the flow of funds, balance sheets, and integrated macroeconomic accounts of the US financial system. It’s really almost too much information to wrap one’s head around.

To help process it all, we have created a bunch of chart publications over the years that visualize quite a bit of it on our website. The saying that a picture is “worth a thousand words” is attributed to newspaper editor Tess Flanders discussing journalism and publicity in 1911. We have always believed that a chart is worth a thousand data points in a time series. Given our chosen profession, we tend to focus on the data for the equity and debt markets in the Fed’s quarterly statistical extravaganza. Let’s focus on equities:

(1) Supply-side totals. Net issuance of equities last year totaled minus $229.7 billion, with nonfinancial corporate (NFC) issues at -$565.7 billion and financial issues at $269.7 billion. The increase in financials was led by a $283.9 billion increase in equity ETFs, the biggest annual increase on record. The decline in NFC issues reflected the impact of stock buybacks and M&A activity more than offsetting IPOs and secondary issues.

(2) Demand-side total. To get a closer view of the demand for equities, let’s focus now on the quarterly data at an annual rate rather than at the four-quarter sum. This shows that equity mutual funds have been net sellers for the past five quarters, reducing their holdings by $151.3 billion over this period. Over the same period, equity ETFs purchased $266.4 billion, with their Q4-2016 purchases a record $485.4 billion, at a seasonally adjusted annual rate. Other institutional investors have been selling equities for the past 24 consecutive quarters, i.e., during most of the bull market! Foreign investors have also been net sellers over this same period.

The bottom line is that the current bull market has been driven largely by corporations buying back their shares, as I have been observing for many years. More recently, we have been seeing individual investors increasingly moving out of equity mutual funds and into equity ETFs. Both kinds of buyers tend to be much less concerned about historically high valuation multiples than more traditional buyers are.

We may be witnessing the beginning of an ETF-led melt-up, which may simply reflect individual investors pouring money into passive stock index funds. Lots of them seem to be more interested in seeking out low-cost funds rather than cheap stocks. In this case, valuation multiples would lead the melt-up, until something happens to scare investors out of those passive funds, which could trigger either a correction or a nasty meltdown. It is obviously a bit late in the game to start only now to be a long-term investor given that stocks aren’t cheap no matter how valuation is sliced and diced.

Wednesday, March 8, 2017

Anniversaries are usually joyous events. This week marked the eighth anniversary of the bull market. On March 3, 2009, President Barack Obama told us to buy stocks: “What you’re now seeing is profit-and-earning ratios are starting to get to the point where buying stocks is a potentially good deal if you’ve got a long-term perspective on it.” On March 6, 2009, the S&P 500 fell to an intra-day low of 666, and never looked back. You might recall (because I’ve reminded you a few times since then) that soon after, I declared that this devilish number was THE low. March 9, 2009 marked the closing low of 676.53. Let’s review some of the accomplishments of the charging bull:

(1) Performance, earnings, and valuation. The S&P 500 is up 249% since March 9, 2009 through yesterday’s close. The forward earnings of the S&P 500 is up 103%. The forward P/E is up 75% (from 10.2 to 17.9).

(2) Blue Angels. Putting all these trends together in our Blue Angels charts shows that the market is certainly flying high. Valuations suggest that stock prices are too high. However, forward earnings for the S&P 500 continues to climb in record-high territory. Furthermore, valuation isn’t too high if President Donald Trump delivers the goodies that he promised, including tax cuts, deregulation, and infrastructure spending. The market clearly liked Trump’s speech before Congress last week, along with his kinder and gentler tone. It was his first truly presidential-sounding performance since he first landed on the political stage.

(3) Fundamentals. Last week’s rally was impressive, and certainly provided a vote of confidence in the President’s economic agenda. That vote was also merited by last Wednesday’s M-PMI, which jumped to 57.7 during February, up from 56.0 during January and 52.0 during October, before the presidential election. Yesterday’s ADP report showing a gain of nearly 300,000 in February payrolls is yet another number suggesting that Trump’s victory unleashed the economy’s animal spirits.

(4) Sentiment. The Bull-Bear Ratio compiled by Investors Intelligence rose to 3.82 last week. That’s the highest since April 2015. Of course, if we all start celebrating the stock market melt-up, the contrarian killjoys will say that such events are usually followed by a meltdown. They’ll observe that the hard work is still ahead, i.e., getting the bullish part of the Trump agenda passed by Congress while blocking the bearish parts that have to do with protectionism.

For now, I continue to dance with the bulls. On a note of caution, let’s recall the infamous last words of former Citi CEO Charles (“Chuck”) Prince. In July 2007, Prince told the FT that global liquidity was enormous and only a significant disruptive event could create difficulty in the leveraged buyout market. “As long as the music is playing, you’ve got to get up and dance. We’re still dancing,” he said. On November 4, 2007, he retired from both his chairman and chief executive positions due to unexpectedly poor Q3 results, mainly attributed to CDO- and MBS-related losses.

Wednesday, March 1, 2017

In a CNBC interview on Monday, Warren Buffett, the Oracle of Omaha, declared that stocks are “on the cheap side.” He has played the Trump rally by putting another $20 billion into the stock market since Election Day. Stocks are cheap, he said, because interest rates remain very low. This suggests that Buffett is betting both on and against Trump. He obviously made a very good decision not to let his personal politics get in the way of joining the animal spirits rally since Election Day. Warren Buffett is a long-time Democrat who supported Hillary Clinton, but he says he agrees with President Donald Trump on some issues—including homeland security as a top priority, boosting economic growth, and increasing the incomes of more Americans who have been hurt by globalization.

Yet, Buffett seems to be betting that interest rates won’t go up much anytime soon. In other words, he isn’t convinced that Trump will succeed in stimulating the economy very much with fiscal policy. He said that Republican leaders will probably have to scale back their tax reform ambitions because their current plan is too complicated to pass Congress, especially if they intend to do something on this by August: “I think complexity will give way to speed.” He expressed skepticism that the Republican tax plan will be revenue-neutral “without the craziest dynamic scoring in the world.” He also said that he doubts that the border adjustment tax (BAT) will see the light of day.

I agree with Buffett on the revenue-neutrality issue. The plan that the administration is outlining suggests a guns-and-butter fiscal approach with more defense spending, no cuts in entitlements, and lower tax rates. It’s hard to see how this won’t lead to higher bond yields, especially if the Fed starts increasing the federal funds rate at a pace closer to normal. (I am still forecasting that the US Treasury 10-year bond yield will range between 2.00%-2.50% during the first half of this year and 2.50%-3.00% during the second half of this year.)

In his interview, Buffett told CNBC on Monday that mixing politics and investment strategies would be a “big mistake.” He added, “Probably half the time [in] my adult life, I’ve had a president other than the one I voted for, but that’s never taken me out of stocks.” That’s been my pitch for a while: Investors should focus on whether the political environment is on balance bullish or bearish, not on whether the policies are right or wrong.

The Oracle of Omaha is credited with having devised the Buffett Ratio to measure stock market valuation. This indicator takes the market capitalization of all stocks traded in the US and divides it by GDP. In an interview he did with Fortune in December 2001, Buffett said, “For me, the message of that chart is this: If the percentage relationship falls to the 70% or 80% area, buying stocks is likely to work very well for you. If the ratio approaches 200%—as it did in 1999 and a part of 2000—you are playing with fire.”

Yet, Buffett thinks that stocks are cheap even though his ratio has risen from a cyclical low of 1.51 during Q3-2015 to 1.59 during Q3-2016. So it is approaching the cyclical high of 1.69 during Q1-2015 and the record high of 1.80 during Q1-2000. That’s using the Fed’s quarterly data on the total market capitalization of US equities excluding foreign issues. Now consider the following related indicators:

(1) S&P 500 Buffett Ratio. A similar ratio using the market cap of the S&P 500 to the revenues of this composite is highly correlated with the Buffett Ratio. It was 1.82 during Q4-2016, nearing the record high of 2.01 during Q4-1999.

(2) Forward ratios. It turns out that the S&P 500 version of the Buffett Ratio is highly correlated with the S&P 500’s price-to-sales (P/S) ratio using forward revenues as the denominator. On a monthly basis, it rose to 1.91 during February, suggesting that the Buffett Ratio is already back to its previous record high, just before the tech bubble burst.

I also monitor the forward P/S ratio on a weekly basis. It rose to a record high of 1.91 during the week of February 16. It is highly correlated with the S&P 500’s forward P/E, which rose to 17.8 during the same week.

There are two alternative economic scenarios that follow from the above discussion. The economy continues to grow in both, though running hotter in one than the other. Of course, there is a third scenario in which the economy falls into a recession. That’s possible if Trump’s protectionist leanings trump his pro-growth agenda. However, I believe that Trump is intent on maintaining free trade, but on a more bilateral basis than a multilateral basis. So here are the two growth scenarios in brief:

Very hot. If Trump delivers a guns-and-butter fiscal program—including most of the tax cuts he has promised along with more defense spending and public/private-financed infrastructure spending—economic growth could accelerate. But so might inflation, given that the economy is at full employment. Government deficits would probably remain large or widen, causing public debt to increase. In this scenario, the Fed would be emboldened to increase interest rates in a more normal fashion rather than gradually. Bond yields would rise. This should be a bullish scenario, on balance, if the boost to earnings from lower corporate tax rates and regulatory costs is as big as promised.

Not so hot. Alternatively, if Buffett is right, and interest rates stay at current low levels, that would imply that Trump’s grand plans for the economy won’t be so grand after all in their implementation. Animal spirits would evaporate. Interest rates would stay low, but valuations would be hard to justify if earnings don’t get the boost that was widely discounted after Election Day.

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ABOUT: Dr. Ed Yardeni is the President and Chief Investment Strategist of Yardeni Research, Inc., a provider of independent investment strategy and economics research. This blog highlights excerpts from our research service, which is designed for investment and business professionals.

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